Bracing for Higher Rates

With inflation ticking higher and the employment situation improving, the Federal Reserve anticipates gradually lifting the benchmark federal funds rate in 2017 and 2018.1 Officials are also discussing plans to shrink the Fed's huge bond portfolio ($4.5 trillion). Phasing out the bond-buying program could reduce overall demand for government bonds and cause some financial market volatility.2

When interest rates go up, the prices of existing bonds typically fall, which can also adversely affect the performance of a bond fund. Fed policies could affect the entire fixed-income market, from U.S. Treasuries and municipal bonds to riskier corporate debt that typically offers higher yields. However, longer-dated U.S. Treasuries (guaranteed by the federal government as to the timely payment of principal and interest) tend to be more rate-sensitive than other types of bonds.

Still, bonds are a mainstay of conservative investors who prioritize the preservation of principal over returns, as well as retirees in need of a predictable income stream.

Bond laddering is a buy-and-hold strategy that can help manage interest rate risk. This process puts an investor's money to work systematically, without trying to predict rate changes. Owning a diversified mix of bond investments might also help cushion the effects of interest rate and credit risk in a portfolio.

Step-by-Step

A ladder is a portfolio of bonds with maturities that are spaced out at regular intervals over a certain number of years. A five-year ladder might have 20% of the bonds mature each year.

Bond ladders may vary in size and structure, and could include different types of bonds depending on an investor's time horizon, risk tolerance, and goals. When short-term bonds from the lowest rung of the ladder mature, the funds are often reinvested at the long end of the ladder. In other cases, a ladder might be part of a withdrawal strategy in which the returned principal from maturing bonds is dedicated to retirement spending.

As interest rates rise, investors who reinvest the funds may be able to increase their cash flow by capturing higher yields on new issues, which could help offset any paper losses on existing holdings.

Individual Bonds vs. ETFs

Buying individual bonds provides certainty, because investors know exactly how much they will earn if they hold a bond to maturity, unless the issuer defaults. Bonds redeemed prior to maturity could be worth more or less than their original cost.

However, individual bonds are typically sold in minimum denominations of $1,000 to $5,000, so creating a bond ladder with a sufficient level of diversification might require a sizable investment. Diversification is a method used to help manage investment risk; it does not guarantee a profit or protect against investment loss.

A similar option involves laddering exchange-traded bond funds that have defined maturity dates. Such ETFs typically hold many bonds that mature in the same year the ETF will liquidate and return assets to shareholders. ETFs may enhance diversification and provide liquidity, but unlike individual bonds, the income payments and final distribution rate are not fully predictable.

The principal value of exchange-traded funds will fluctuate with changes in market conditions. Supply and demand for ETF shares may cause them to trade at a premium or a discount relative to the value of the underlying shares. Shares, when sold, may be worth more or less than their original cost. Bond ETFs are subject to the same inflation, interest rate, and credit risks associated with their underlying bonds.

Exchange-traded funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

Wells Fargo Advisors does not render legal, accounting, or tax advice. Please consult your tax or legal advisors before taking any action that may have tax consequences. Wells Fargo Advisors did not assist in the preparation of this material, and its accuracy and completeness are not guaranteed.

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